The chaos of internal bank controls

IE Focus Newsletter November 2008November 2008 | By Jose Estevez, Professor at IE Business School

The collapse of Lehman Brothers or the fraudulent activities of a broker at Société Génerale reveal the chaos that reigns in banksâ?? internal control systems. The world economic recession and, in particular, that of the banking and financial sector is giving rise to serious problems. Lehman Brothers was considered as one of the financial institutions with the best contingency plans and yet it was not enough to save it from collapse. Another clear example is that of Societe Generale, where internal controls were incapable of detecting the fraudulent activities of one of its brokers.

Some experts suggest that the internal controls of many institutions are nothing more than “mere plans on paper”, that they are not operational, that they have never been tested and that employees “ignore them”, with no monitoring process in place as far as the institution is concerned. This is paradoxical, since a control system is characterised by the presence of elements that make it possible to influence the way in which the system works. A control system must guarantee stability and, in particular, be impenetrable as far as model errors and interference are concerned. Furthermore, it must be as efficient as possible and comply with a preset criterion. Normally, this criterion consists of control over input variables being possible, thus preventing sharp practices.

We are all familiar with the theory, but why has it not worked in financial institutions? The real situation is that, in some cases, it has worked, but while they were earning succulent profits, many consultants and managers ignored breaches of their internal controls. There is also another reason why it has not worked: the lack of good institutional information management.